The ETF industry has traditionally been dominated by products based on market capitalization weighted indexes that are designed to represent the market or a particular segment of the market. They provide a low-cost, convenient and transparent way of replicating market returns. But many investors have realized that capitalization weighted indexes are not the most efficient way of investing, at times.
On the other hand, some investors who believe that it is possible to beat the market by superior stock selection opt to invest through active managers. However, most investors have been disappointed with the performance of active managed funds, as returns generated by them often do not justify the higher costs associated with them.
Smart beta strategies seek to combine the best of active and passive investing, i.e., outperforming the market while keeping costs low. While not so popular with retail investors yet, they have already become very popular with institutional investors.
What is Smart Beta?
In simple words, 'beta' can be defined as the correlation of a security's return with the market return. Smart beta indexes attempt to select stocks that may have better risk-return performance than the market.
Many ETF industry experts do not like the name since the word 'smart' may suggest that the traditional strategies are 'not so intelligent' or rather 'dumb'. They prefer to call these 'alternative' or 'advanced' beta strategies instead of 'smart'. Investors should probably understand that these indexing methods are just different and may be better. There is nothing really smart or intelligent about them.
This space offers a number of choices to investors, starting from simplest equal-weighting to fundamental weighting which assigns weights to stocks based on their fundamental characteristics such as revenue/earnings, cash flow, dividends, etc. Others seek to exploit "anomalies" present in the market.
Best Smart Beta ETFs
Not all these strategies have been able to deliver superior results. Strategies like low volatility, high beta and momentum outperform only in certain market conditions and investors are not very good at market timing.
And, while smart beta ETFs follow rules based methodologies, not all are very transparent and simple to understand. Most of them charge high fees for their complicated strategies, which may or may not produce commensurate results.
At the same time, there are some smart beta ETFs that follow easy to understand strategies and add value to investor portfolios. These have the potential to outperform the market over the long term. We have highlighted five such excellent smart beta ETFs.
iShares Core Dividend Growth ETF (NYSEARCA:DGRO)
The product holds companies that have a history of consistently growing their dividends and are likely to continue growing dividends. Holdings are weighted by dividend dollars.
I believe that companies with uninterrupted dividend growth records usually have solid balance sheets and strong cash flows. So, these strategies outperform the market over time and also provide stability and downside protection during market downturns, in addition to growing income streams.
The ETF doesn't have a lot of exposure to rate sensitive sectors and would be a good choice for investors worried about the rising rate environment.
It has a low expense ratio of 0.08%. The ETF had beaten the S&P 500 index since inception in June 2014. It is up 38.7% while SPY has risen 35.6% over the past three years.
Vanguard Dividend Appreciation ETF (NYSEARCA:VIG)
VIG is the most popular ETF in the dividend space with AUM exceeding $24.8 billion. It is my favorite dividend ETF. Like DGRO, this product also focuses on dividend growth. It holds high quality stocks that have a record of increasing dividends over the past decade.
The product currently holds 185 securities in its basket. The ETF charges just 8 bps in annual fees while its dividend yield is 2.05%.
VIG has delivered a return of 114.6% over the past ten years, compared to SPY's 110.5% return.
Guggenheim S&P 500 Equal Weight ETF (NYSEARCA:RSP)
Each of the stocks that make up the S&P 500 index are equally weighted in this product rather than by market capitalization. Due to equal weighting, this product has higher exposure to smaller companies that are more volatile but have higher return potential as well.
At the same time, equal weighting largely reduced single stock risk. Since its inception about 10 years back, the fund has significantly outperformed the broader market. It is up 128%, while SPY is up about 110% over the past ten years.
PowerShares FTSE RAFI US 1000 Portfolio (NYSE:PRF)
PRF is based on a RAFI index that aims to select stocks based on four fundamental measures - book value, cash flow, sales and dividends. The 1,000 equities with the highest fundamental strength are weighted by their fundamental scores.
Top holdings include Exxon Mobil (NYSE:XOM), Apple (NASDAQ:AAPL) and Chevron (NYSE:CVX), but the asset base is pretty well spread out with top 10 holdings accounting for less than 18% of the total. The product has an expense ratio of 39 basis points.
The ETF made its debut in December 2005 and has outperformed the Russell 1000 index since inception. Over the past ten years, PRF is up 118%, compared to SPY's rise of 110.5%.
Guggenheim S&P 500 Pure Value ETF (NYSE:RPV)
S&P 500 pure style indexes divide one-third of S&P 500 market capitalization as 'Pure Growth and one third as 'Pure Value'. These two buckets have no overlapping stocks. Index constituents are weighted by their style scores as opposed to market cap. Thus, 'pure' approaches eliminate any overlap between growth and value.
RPV tracks the S&P 500 Pure Value Index and holds 114 securities in its basket. Deep focus on value stocks is evident from P/E and P/B ratios of 14.96 and 1.49, respectively. It has risen 128% over the past ten years, handily beating the broader market.
Not all smart beta funds have outperformed their market-cap weighted counterparts. Further, they usually have slightly higher expense ratios and many also come with higher trading costs due to lower volumes.
But some of them have been consistently outperforming and are worth a look due to their excellent strategies. To begin with, investors should use products based on simple and transparent alternative methodologies that are easy to understand and are not too expensive.